Why You Should Trash This Government Bond

Several years ago, the U.S. Treasury experienced difficulty marketing government debt. The reason was obvious: investors were waking up to the fact inflation was slowly eroding away the value of government issued bonds.

TIPS became an instant hit after they were created, and remain popular today.

Here's how TIPS work:

The face value of the bond is adjusted semi-annually using the Consumer Price Index (CPI). The interest rate remains constant but the interest paid is based on the adjusted face value.

To illustrate, I give you a hypothetical TIPS with a $1,000 face value, paying 2% interest:

Now, check out what happens with a two-percentage point increase in inflation:

It's pretty nifty. Interest is paid after the inflation adjustment is made, thus guaranteeing a real rate of return. In addition, the inflation-adjusted face value is paid at maturity. But just one question…who calculates the adjustment (a.k.a. inflation) rate?

The government (borrower) does, and therein lies the rub. There is every incentive in the world to deflate the inflation rate in order to reduce the amount owed on the bond in real terms.

Understating Inflation

Inflation used to be measured by calculating the rate of change in the cost of a constant basket of goods from one year to the next. But in 1996, conveniently one year before TIPS was born, the methodology changed.

Inflation began to be calculated using the substitution effect, weighting and hedonics. If you didn't learn those terms in Econ 101, just stay with me.

For the substitution effect, imagine you're grocery shopping. Your favorite cereal usually costs $3, so you reach for it -- until you realize the price has gone up to $4.50. So, you decide to opt for a different cereal within the $3 price range. Essentially, the substitution effect occurs when consumers replace a more expensive product with a less expensive one.

The substitution effect sounds reasonable enough but the problem is the "CPI calculators" assume everyone will, in fact, opt for the cheaper cereal.

The next bit of chicanery is the use of weighting. When the price of an item increases too quickly, the government statisticians assume we'll use less of the item. Consequently the item is given a lesser weight.

The main purpose of weighting is to dilute the impact of rapidly rising healthcare costs by only using a fraction of those costs to calculate the consumer price index.

Last but not least is the grossest of all the gross distortions: hedonics. The name sounds sinister enough and then you get to the details. The best way to explain hedonics is with an example, which I will lift from a book called "The Crash Course" by Chris Martenson.

The book reveals a hedonics-based CPI price adjustment made for a television with a new digital tuner. The Bureau of Labor Statistics deemed the pleasure derived from the new tuner to be worth $135. So for CPI-reporting purposes, the $330 TV set was reduced in price $135 from the prior year even though the actual retail price at the store remained unchanged over the same time period.

Through the use of these statistical tricks, it seems the government's ultimate goal is to arrive at an inflation rate that tracks the cost of everything except goods with rising prices.

The Real Inflation Rate

Economist and government skeptic John Williams, uses the old method for calculating inflation and concludes the BLS understates inflation by approximately 7 percentage points per year.

Now, back to our hypothetical TIPS. Remember, we were using the 2% dummied-up CPI rate, which yielded a 4.04% total return. If you'll recall, after the first inflation adjustment at 2%, our bond looked like this.

But now we know, the real inflation rate is likely closer to 9%, which means our TIPS is not protecting us from squat. In fact, we're actually losing money in real terms.

The Investing Answer: Here's a tip, avoid TIPS. A much better inflation-hedge is gold. However, physical gold isn't a great alternative to TIPS because it provides no income stream. But some gold mining stocks do offer an income stream in the form of dividends.

Although gold stock yields are nothing to write home about, they do offer a source of income nonetheless as well as great capital appreciation potential in an inflationary environment.